John Tamny: Both sides wrong on cliff

Supply-siders and Keynesians don't agree on much these days, but when it comes to the alleged "fiscal cliff," both sides are in agreement that jumping off this ledge would bring tragic economic consequences. Though a strong believer in supply-side principles, I believe even more strongly that conventional wisdom is nearly always wrong. It's wrong here.

Before getting into why the grand assumptions surrounding the fiscal cliff are ridiculous, it's best to explain why we'll never reach this cliff, more of a ranch-style-house drop onto soft ground. We won't because the incentives that drive politicians ensure a deal.

That's the case because with the economy still limping, very few politicians will want to be on record as having voted to raise rates of taxation. Every member of the House of Representatives is up for re-election in 2014, as are a third of senators, and with an eye on re-election they're not going to vote for large tax increases. With taxes, they'll likely compromise: lower rates in return for a reduction in economy-distorting tax loopholes.

Considering spending, though it nearly always occurs at the expense of growth, politicians exist to spend our money. That's what animates them, and it's true irrespective of party affiliation. Because spending is breath to the political class, there's no way they'd ever allow automatic spending cuts or, "sequestration."

Turning to why supply-siders and Keynesians alike are so fearful of the "cliff," that's easy, too. For Keynesians, they're deluded by the false belief that government spending is an economic stimulant and that automatic reductions in spending by the feds would directly subtract from gross domestic product growth.

In an artificially absurd sense, the Keynesians are right. GDP would decline in the very near term amid automatic spending cuts, but all this tells us is that GDP is a worthless number. Governments have no resources, so for governments to spend is for them to tax or borrow limited resources from the private sector that will be consumed in wasteful ways.

Economies are nothing more than a collection of individuals, and when we break the U.S. economy down to the individual, it's easy to see how wrong the Keynesians are. Indeed, are you better off when the federal government taxes away your earnings and consumes limited capital that might otherwise fund a future Microsoft? No? Well, you're the economy.

In short, government spending is an economic retardant. Because it tautologically weighs on economic growth, any reduction in the burden that is government would boost the economy.

Supply-siders at first glance have a more compelling case. If we reach Jan. 1 without a deal, the 2003 tax cuts on income, capital gains and dividends for top earners automatically go up.

It's the "vital few," or the 1 percent whose economic activism (think Amazon, FedEx and Google) employs us and makes us more productive, so any increase in the cost of work and investment for the most productive would on its face be a negative. No doubt that's true, but implicit in the narrative from the supply-siders is the belief that the 2003 tax cuts actually worked as advertised.

The reality is quite different. As evidenced by the weak economy, it's simply the case that we're not as productive as we should be, and investment is not as robust as it should be. A compelling reply here is that even higher taxes would smother that which is gasping for breath even more, and take us into a recession.

What's missed by some, but not all supply-siders, is that we're already in a recession. GDP is once again a worthless number, but if we remove government spending from the calculation, there's not much growth to speak of at all.

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Why the recession? This one's obvious, and it explains why the much-vaunted 2003 Bush tax cuts at the heart of supply-side hand-wringing over the "fiscal cliff" haven't worked: the weak dollar since 2001 has served as a massive tax on work and investment that has robbed the 2003 tax cuts of any major impact.

When money is devalued, the size of our paychecks shrinks. Supply-siders correctly understand that income taxes eviscerate our paychecks, but not enough understand that currency devaluation achieves the same, and that's why devaluation always correlates with slow growth. Devaluation is a tax on work.

Of course, it's always the case that investment is what pushes labor forward, but the problem at the moment is that whether the capital-gains rate is 15 percent or 20 percent, the dividend tax 15 percent or 39 percent, there's very little incentive to invest. Indeed, with policy in favor of dollar devaluation, why commit capital to economy-enhancing ideas if any returns come back in dollars that have shrunken in value?

Tax cuts on income, investment returns and dividends are great, but they're largely irrelevant at the moment. Worse, their wonders are being discredited by dollar destruction that began under George W. Bush, and that has continued under President Barack Obama.

Back to the fiscal cliff: We're never going to reach it, given the incentives that drive politicians. That said, don't buy all the hysteria about what's over the cliff. Government spending reduces real growth, while tax cuts only work if paired with a strong dollar. Both sides miss the point.

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